The SEC climate-related disclosure rules: worth the wait?

The new rules apply to public companies in the United States and those seeking to go public through the publication of a prospectus, including foreign private issuers (FPIs) that are registered with the SEC, although the dates at which the new requirements take effect depend on the size and type of company. The earliest compliance dates will be for "large accelerated filers", with the required disclosure covering the fiscal year 2025 to be published in 2026.

Although the Final Rules only apply to SEC registrants (and companies seeking to go public and filing a prospectus in the United States), it is possible that unregistered FPIs seeking to raise capital from U.S. investors in exempt private placement transactions (in so-called "144A" transactions) may need to expand their climate-related disclosure in offer documents in order to conform to investor expectations in the United States.

This note will focus specifically on the applicability of the new rules to FPIs, particularly regarding how the U.S. rules sit alongside the U.K. and E.U. disclosure regimes.

The SEC's mandate and mission is to maintain fair, orderly and efficient markets, with a focus on investor protection and capital formation.

In this context, it is important to note that although the Final Rules concern disclosure obligations for public companies (and those going public), they do not prescribe or prohibit corporate behaviour with respect to their emission levels or environmental impact generally. These are not environmental rules, per se, which would be outside of the SEC's remit but would rather fall within the jurisdiction of Congress and the U.S. Environmental Protection Agency. The Final Rules are, therefore, intended to ensure that investors are able to understand "how climate-related risks affect a registrant’s business and financial condition and thus the price of the registrant’s securities" through the provision of clear and consistent disclosure to the market. In that sense, they are very much aligned with climate disclosure requirements in the UK, under the Taskforce on Climate-related Financial Disclosures ("TCFD") framework, and under the standard on climate-related disclosures published last year by the International Sustainability Standards Board ("ISSB"), which is beginning to see adoption worldwide.

At 886 pages, the SEC's release setting out the Final Rules goes into some detail regarding the new disclosure requirements, including those which will be required in the footnotes to the financial statements and information which will be provided in other sections of the relevant annual report or prospectus.

Disclosures required outside of the financial statements include:

• For large accelerated filers and accelerated filers, and only if material, Scope 1 GHG emissions (emissions that occur from sources that are controlled or owned by company) and Scope 2 GHG emissions (indirect GHG emissions associated with the purchase of electricity, steam, heat, or cooling), noting that none of the proposed requirements to disclose scope 3 emissions are part of the Final Rules;
  
  
• A description of climate-related governance and oversight (including any relevant committees) by both the Board of Directors and management;
  
  
• The material impact (or reasonably likely material impact) of climate risks on the company’s strategy, results of operations or financial condition, including both in the short term (i.e., in the next 12 months) and in the longer term (i.e., beyond the next 12 months);
  
  
• The manner in which the company identifies, assesses and manages material climate-related risks; and
  
  
• Climate targets and goals, if material and if announced or otherwise used by the company, as well as annual updates on any progress made towards these targets and goals.

Disclosure required in the footnotes to the financial statements must include the aggregate amount of expenditures, losses, capitalised costs and charges, incurred as a result of severe weather events and other “natural conditions", as well as how such events and conditions impact the company's estimates and assumptions, if material. 

Further, the footnotes to the financial statements must disclose information concerning carbon offsets and renewable energy credits or certificates (RECs), if they are material part of the company's plan to achieve its stated climate targets and goals.

The regulatory reporting framework in the European Union, as set out in the Corporate Sustainability Reporting Directive ("CSRD"), includes the concept of "double materiality", whereby companies are required to consider the impact of a given ESG issue both in terms of its implications for the company’s financial value and the company’s impact on the world at large.  This double materiality framing casts a wide net for ESG related disclosure for companies within the scope of the EU framework.

The Final Rules, in contrast, concern only climate-related disclosure (excluding many other potential ESG issues) and then only those which are "material" to the company. The SEC goes to some length to stress that the materiality analysis for purposes of the Final Rules is consistent with "traditional notions of materiality", requiring quantitative and qualitative considerations.

Per the SEC and the U.S. Supreme Court, a matter is material if "there is a substantial likelihood that a reasonable investor would consider it important when determining whether to buy or sell securities or how to vote or such a reasonable investor would view omission of the disclosure as having significantly altered the total mix of information made available".

The "reasonable investor" test is interesting when applied to the disclosure required by the Final Rules. By way of example, consider an NYSE-listed FPI with manufacturing facilities and clients located outside of the United States. The company's emissions, regardless of the level, may not currently be material to their strategy, results of operations, or financial condition. However, if the determination is made that their investors or the broader pool of investors are reducing exposure to large emitters, then the company's emissions may indeed be determined to be material, even in the short term (i.e. the next 12 months).

The Final Rules also require the hypothetical manufacturer to look further out than 12 months, which means our hypothetical FPI would likely be able to envision a risk of regulatory requirements imposed in the United States, Europe or elsewhere, which would be reasonably likely to have a material impact on the business, its financial condition or strategy. 

The SEC cited numerous comment letters received from asset managers which were supportive of the establishment of clear and consistent climate-related disclosure by SEC registrants. As per one comment letter received by the SEC: “[M]aterial risks and opportunities associated with climate change as fundamental financial factors that impact company cash flows and the valuation investors attribute to those cash flows. Regulatory changes, physical risks, and changing consumer decision criteria and preferences are all factors that asset managers need to understand and integrate into their investment processes to make optimal investment decisions on behalf of their clients.”

Although fund and asset managers may applaud the increase and standardisation of disclosure by SEC registrants, a variety of fund and asset managers are themselves registered with the SEC and will therefore need to provide disclosure in accordance with the Final Rules. For example, listed investment firms will need to consider and potentially provide disclosure concerning how weather events such as flooding might impact their real estate investments. Further, such firms would be required to provide disclosure regarding transition plans addressing material risks or opportunities and net zero plans announced or otherwise used by the company.

It is also worth noting the amendments adopted by the SEC on 20 September 2023 to Rule 35d-1 (the Names Rule) under the Investment Company Act of 1940 (the 1940 Act). The Names Rule prohibits registered funds from using “materially deceptive or misleading” names.  According to the rule, registered investment companies whose name suggests a particular type of investment must invest at least 80% of the value of their assets in those investments.  The SEC expanded the scope of the Names Rule in 2023 to include registered funds with names that suggest the fund focuses on investments or issuers with particular characteristics, including ESG.

In May 2022, the SEC also proposed changes to the rules and forms under the 1940 Act and the Investment Advisers Act of 1940 (the Advisers Act) to require registered investment advisers, certain advisers that are exempt from registration and registered investment companies to provide additional information regarding their ESG investment practices. 

These changes to the 1940 Act and the Advisers Act have not yet been finalised or adopted.  It seems likely that the current leadership at the SEC would seek to finalise these changes in advance of the upcoming November election.

Annual reports and other public disclosure from U.S. public companies, and those going public via a prospectus, will inevitably include unverifiable forward-looking estimates, projections, plans and objectives.

Given the prevalence of litigation in the United States, particularly around prospectus and other corporate disclosure, Congress created a safe harbour for certain forward-looking statements with the passage of the Private Securities Litigation Reform Act (PSLRA) in 1995. 

The PSLRA contains a safe harbour provision that protects the makers of forward-looking statements from liability where either:

• The statements were immaterial;
  
  
• The plaintiff fails to show that the defendant had actual knowledge that the statements were false or misleading when made; or

• The defendant identified the statements as forward-looking and provided meaningful cautionary language identifying important factors that could cause actual results to differ materially from those in the forward-looking statement

The Final Rules require companies to provide significant forward-looking information. The Final Rules therefore extend the PSLRA safe harbour for forward-looking climate disclosure concerning transition plans, scenario analysis, the use of an internal carbon price used by the company and targets and goals set by the company.

A key question many firms are asking how they can avoid duplication preparing disclosures to meet the various requirements under different regimes. The SEC observes in the Final Rules release that "a meaningful number" of firms subject to disclosure requirements under the Final Rules will be subject to climate-related disclosure requirements in other jurisdictions.

The Final Rules release is peppered with references to the Task Force on Climate-related Financial Disclosure ("TCFD") and the GHG Protocol and the SEC has explicitly sought to incorporate the principles which are already in use in other disclosure regimes. Although the SEC has clearly had regard to those regimes, it has stopped short of full alignment.

TCFD is identified as a common alignment theme, across recognised reporting frameworks including GRI, SASB and CDP, as well as the UK's FCA rules for climate reporting by listed issuers, and rules for large companies under the Companies Act.

The SEC notes that some commentators were in favour of a more explicit acknowledgement of the climate standard established by the International Sustainability Standards Board (the ISSB) and for the SEC to recognise it as an equivalent regime.  The SEC expressly declined that recommendation, based on the fact that at the time of writing, no jurisdictions had integrated ISSB standards into their disclosure regimes. This does leave the door open to future recognition decisions, which may become relevant in the UK if, as expected, the UK adopts ISSB sustainability standards into its national rules.

During the proposal phase, some commentators had suggested that the SEC may become an equivalent regime to sustainability reporting under CSRD, if it included scope 3 emissions. CSRD does envisage that the Commission will make decisions on the equivalence of sustainability reporting standards used by third country issuers which would effectively exempt non-EU undertakings otherwise subject to CSRD from its reporting requirements. However, it is clear that such a decision will only be taken where the third country standard requires reporting on environmental, social and governance factors (therefore, not just climate), and where such reporting is on a double materiality basis. At present, there is no regime which meets this high bar, including the SEC's Final Rule.

The emphasis on materiality in the Final Rules does raise interesting questions about the extent to which omissions from a CSRD sustainability report based on a lack of financial materiality should align with omissions from an SEC climate disclosure. Under CSRD, all disclosures under the E1 Climate Change European Sustainability Reporting Standard ("ESRS") may be omitted where the reporter deems climate not to be material, but the reporter must provide a detailed explanation of the conclusions of its materiality assessment with regard to climate change, and also include a forward-looking analysis of the conditions that could lead this materiality conclusion to change in the future. In common with the rules for CSRD reporting generally, individual disclosure requirements can be omitted where not material (those that are derived from other EU laws, which includes emissions disclosures, must be indicated as not material). Therefore it seems to be within the bounds of the law, under both the EU and the SEC Final Rules, for a reporting entity to decline to disclose its greenhouse gas emissions where it deems them not material. However in the EU, perhaps in contrast to the US where non-financial reporting has less precedent, emissions disclosures are likely to be viewed as the bare minimum, with potential implications for stakeholder relations (and auditor scrutiny) if they are omitted.

In general, besides taking due account of variations in the definitions of key terms and the requirement to assess the materiality of each disclosure, the Final Rules are unlikely to be too much of a challenge for firms already reporting on climate under TCFD, ISSB or CSRD. Points of variance and overlap include the following:

• All pillars of TCFD are included, namely governance, strategy, risk management, whereas "metrics and targets" becomes "Targets and goals" under the Final Rules. Although not precisely mapped, the Final Rules also broadly align to all TCFD recommended disclosures with the exception of metrics and targets. The disclosure are however focused solely on climate-related risks, not opportunities. Given its double materiality lens, CSRD additionally requires identification and reporting of climate-related impacts. The Final Rules do however pull in certain additional requirements from the TCFD Guidance for All Sectors; for example, the requirement to consider the impact of climate-related risks on the organisation's products, services and supply chain.
  
  
• As noted above, the reliance on carbon offsets to achieve climate targets or goals, if material, must be disclosed, which aligns with both CSRD and ISSB (but is not required under TCFD). The Final Rules additionally require that disclosers report the use of Renewable Energy Credits (RECs), equivalent to Renewable Energy Guarantee of Origin (REGOs) in the EU. The CSRD does not require such disclosure.
  
  
• Scenario analysis, broadly acknowledged as one of the most challenging aspects of climate-related financial reporting, is not required under the Final Rules.  If scenario analysis is used by the company, however, and the results demonstrate a reasonably likely material impact on the business, such information should be disclosed. Scenario analysis is a requirement under TCFD and ISSB. Under CSRD, there is an implied obligation for an entity disclosing under the E1 Climate Change ESRS to conduct scenario analysis, though arguably it would be open to such an entity to disclose that it had not conducted any such analysis. 
  
  
• The Final Rules do not require the use of any specific protocol or standard to calculate GHG emissions. ISSB has a positive obligation to calculate emissions in accordance with the GHG Protocol, whereas CSRD requires reporters to "consider the principles and requirements" of the GHG Protocol and to use its 15-category definition of scope 3 emissions.

First things first, the Final Rules have been adopted by the SEC and will go into effect this spring. That does not mean, however, that the controversy over the Final Rules has been settled.

Companies required to expand their climate-related disclosures will incur significant costs.  Comments on the draft rules included a wide range of estimated compliance costs but the SEC assumes that initial compliance costs could be up to $500,000 in the first year and up to nearly $400,000 in subsequent years.  The SEC recognised that there would likely be a wide range of costs for companies over time, with annual compliance costs, averaged over the first 10 years of compliance, ranging from less than $200,000 to over $700,000.

The legal challenges to the rules have already begun.  The Final Rules were adopted on Wednesday 6 March 2024. The first suits were filed that day and by the end of the day on 8 March 2024, a combined 13 states had challenged the rules in two different U.S. Courts of Appeal, taking issue with the process through which the Final Rules were adopted, arguing that the Final Rules exceed the SEC’s authority and challenging the required disclosure as impermissible compelled speech under the First Amendment to the US Constitution. Indeed, the 5th Circuit put the implementation of the Final Rules on hold on 15 March. More challenges are expected be filed, from both the left and right.

This is not a surprise. Given the certainty of future challenges in court, the SEC pared back the Final Rules significantly from what was originally proposed in order maximise the possibility that the Final Rules would survive. Whether this was enough to ensure safe passage through the legal challenges is uncertain. Time (and perhaps the Supreme Court) will tell.